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DEPARTMENTAL INTERPRETATION AND PRACTICE NOTES NO 39 PROFITS TAX

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									                                                       Inland Revenue Department
                                                               Hong Kong




DEPARTMENTAL INTERPRETATION AND PRACTICE NOTES

                                     NO. 39


                               PROFITS TAX

            TREATMENT OF ELECTRONIC COMMERCE


           These notes are issued for the information and guidance of taxpayers
and their authorised representatives. They have no binding force and do not
affect a person’s right of objection or appeal to the Commissioner, the Board of
Review or the Courts.




                                                LAU MAK Yee-ming, Alice
                                              Commissioner of Inland Revenue

July 2001




                         Our web site : http://www.ird.gov.hk
   DEPARTMENTAL INTERPRETATION AND PRACTICE NOTES

                                  No. 39

                               CONTENT



                                                                  Paragraph

Introduction                                                              1

Profits tax overview                                                      4

A trade, profession or business carried on in Hong Kong                   6

The locality of EC profits                                               13
      Example 1 : Trading business
      Example 2 : Servicing business
      Example 3 : Manufacturing business

Characterization of income                                               19
     Example 4 : Electronic ordering and downloading of digital
                  products
     Example 5 : Application hosting arrangements
     Example 6 : Application service provider (ASP)
     Example 7 : Content acquisition transaction

Conclusion                                                               26
INTRODUCTION

           The Inland Revenue Ordinance (the Ordinance) does not contain any
provisions that deal specifically with the taxation of electronic commerce (EC).
The tax consequences of EC transactions must therefore be determined by
reference to the Profits Tax provisions of the Ordinance which can apply to any
trade, profession or business, having regard to established accounting standards
and principles laid down by the courts. In considering particular issues,
guidance may also be obtained from Departmental Interpretation & Practice
Notes (DIPN) No. 21, concerning “Locality of Profits” and DIPN No.17,
concerning “The Taxation of Persons Chargeable to Profits Tax on behalf of
Non-residents”.

2.         Our tax policy with regard to EC is to adopt the principle of
neutrality of treatment. In essence, the Ordinance is applied to EC on the
same basis as to conventional forms of business. By doing so, no particular
business form should have either an advantage or a disadvantage as far as
taxation is concerned. This approach is intended not only to be pragmatic, but
also to be consistent with that taken by our major international counterparts.
In this way, our simple tax system should not be prejudicial to the development
of EC in Hong Kong.

3.          EC is developing at a rapid pace, with EC business models
constantly evolving. As such, it would be of little point to attempt to describe
in detail in this Practice Note how the Ordinance applies to particular forms of
EC that are currently in vogue. At the present stage of development, it is
considered more appropriate to focus on the broad taxation principles that
currently apply to EC generally, and are likely to continue to do so in the future.
The Department’s practices in relation to EC and the suitability of our taxation
legislation will, of course, be reviewed in the light of developments. This
Practice Note will be updated as and when the need arises.



PROFITS TAX OVERVIEW

4.         The basic charge to Profits Tax is contained in section 14 of the
Ordinance. The following three conditions need to be satisfied before a charge
to tax can arise under this section -
              the person concerned must carry on a trade, profession or
              business in Hong Kong;
              the profits to be charged must come from the trade, profession or
              business carried on by the person in Hong Kong; and
              the profits must be “profits arising in or derived from Hong
              Kong”.

5.        In addition, under section 15(1) of the Ordinance, certain sums not
otherwise chargeable to tax are deemed to be receipts arising in or derived from
Hong Kong from a trade, profession or business carried on in Hong Kong and
accordingly are chargeable to Profits Tax. These include sums received for the
use of or right to use in Hong Kong a patent, design, trademark, copyright
material or secret process or formula or other property of a similar nature.
Section 15(1) is further discussed in paragraphs 19-25 below.


A TRADE, PROFESSION OR BUSINESS CARRIED ON IN HONG
KONG

6.         The Ordinance does not exhaustively enumerate the various
situations where a person is considered to be carrying on a trade, profession or
business in Hong Kong. Whether or not a person is doing so is largely a
question of fact and degree, which can only be decided on after examining all
the circumstances of the case. Although it is not essential for a person carrying
on a trade or business to have an office, staff or organisation, where none of
these attributes exists, there must be other clear evidence of carrying on a trade
or business – see Hong Kong Inland Revenue Board of Review Decisions,
D38/96, 11 IRBRD 529, D42/98, 13 IRBRD 280 and D132/98, 13 IRBRD 613.

7.         Extensive activities are not necessarily required before it can be said
that a person is carrying on a trade or business. A relevant authority in this area
is the decision of the Privy Council in American Leaf Blending Co. Sd Bhd v.
Director General of Inland Revenue [1978] STC 561, where Lord Diplock said,
at page 565, –

          “ … In the case of a company incorporated for the purpose of
            making profits for its shareholders any gainful use to which it puts
            any of its assets prima facie amounts to the carrying on of a
            business.”


                                        2
While the presumption referred to in Lord Diplock’s statement is an important
one, each case has to be decided on its own facts. Accordingly, the
Department accepts that not every gainful use of a company’s assets would
necessarily lead to the conclusion that a trade or business is being carried on.

8.          EC transactions may obviously be conducted in many different ways
and be concerned with a very wide range of goods and services. As such, many
different factors may be relevant in determining whether a person engaged in
EC is carrying on a trade or business in a particular jurisdiction. Apart from
the nature of any contracts concluded in the jurisdiction, it may be relevant to
note factors such as the places where goods are stored and delivered by the
person, services are provided, payments are made and received, purchases and
sales are made, bank accounts are maintained, and business back-up services
are provided. It should also be noted that such operations could be performed
by either the taxpayer or his agents. All such operations should be examined
in the context of the nature of the business and the business model under which
it is being conducted. It is also pertinent that an enterprise carrying on an EC
business may require significantly less physical operations, personnel and
facilities in a particular location than an enterprise engaged in a conventional
business.

9.         In relation to this issue it should be noted that the Department is of
the view that the mere presence of a server (even if an intelligent one – i.e.
capable of concluding contracts, processing payments or delivering digital
goods) in a particular jurisdiction without the involvement of human activities
in the same jurisdiction would not generally amount to the carrying on of a
business there. In deciding the issue of whether a business is carried on in
Hong Kong, the Department would look beyond the server and examine the
extent of the person’s other operations in Hong Kong.

10.        It is appropriate to comment here on the situation where a person
whose head office is situated outside Hong Kong has a permanent
establishment (PE) here. The term “permanent establishment” is defined in
Rule 5 of the Inland Revenue Rules to mean “a branch, management or other
place of business, but does not include an agency unless the agent has, and
habitually exercises, a general authority to negotiate and conclude contracts on
behalf of his principal or has a stock of merchandise from which he regularly
fills orders on his behalf.” As such, if a non-resident person has a PE within


                                       3
the terms of Rule 5 in Hong Kong, there can be no doubt that the non-resident
is carrying on a trade or business in Hong Kong (although the presence of a PE
is not essential for reaching such a conclusion). Where such a person derives
profits from Hong Kong, Rule 5 provides for the basis of computing the
person’s profits assessable to Profits Tax.

11.       With the development of EC the question has arisen as to whether a
non-resident person selling products through a server it owns or rents and
operates in Hong Kong should be regarded as having a PE here. However, it
is commonly understood that the words “branch, management or other place of
business” in Rule 5 imply the presence of a physical place and personnel.
Accordingly, the Department will generally accept that the mere presence of a
server does not constitute a PE.

12.        The concept of PE is also a common feature in double taxation
agreements. In this regard, it is pertinent to briefly mention the position of the
Organisation for Economic Co-operation and Development (OECD). The
position taken by the OECD is that a server at the disposal of a business (i.e.
owned or rented by it) can only be regarded as a PE of the business if an
essential and significant part of its business activities are conducted through the
server. This is the case even if no personnel of the business are required at the
server’s location for the operation of the server. However, the OECD’s
concept of PE is mainly relevant in the context of tax treaty arrangements and
its definition of PE is worded slightly differently from that of the Inland
Revenue Rules. In relation to the interpretation of domestic law, the
Department holds the view mentioned in paragraph 11 above and will continue
to apply established tax principles and practices.



THE LOCALITY OF EC PROFITS

13.        The Ordinance does not contain a comprehensive set of source rules.
Consequently, in order to determine the source of particular profits, guidance is
often obtained from judicial precedents. In this regard, the courts have often
stated that the determination of source is a practical hard matter of fact.
Furthermore, the courts have tended to emphasize certain factors as being
relevant in determining the source of particular types of income. In DIPN No.
21, on the locality of profits, some of the particular factors are illustrated on a


                                        4
broad principle basis. The Practice Note is equally applicable in deciding the
locality of profits where EC is involved. In general terms, however, it must
be stressed that the proper approach to be taken in determining the locality of
profits is to ascertain what were the taxpayer’s operations which produced the
relevant profits and where those operations took place.

14.        In the context of EC, business operations are commonly automated
to a significant extent, with the consequence that physical activities are
comparatively reduced. A business may use a server to provide a
communication linkage between trading parties for a variety of purposes. For
example, a server may be used by a business to give information about its
products and services, to process on-line purchase orders, to deliver digitized
products or services electronically, or to process payments. All these
activities may be automated and carried out using a server located outside
Hong Kong.         However, the place where these automated server-based
activities are carried out does not, of itself, determine the locality of profits.
They have to be weighed against the core business operations required to
conduct the EC transactions, which are usually carried out within a physical
office (including operations arising from the need to automate, manage and
control the virtual shop-front or back-office). It is also relevant that,
irrespective of the EC model adopted, it is usually the case that tasks
undertaken through a server are performed according to pre-designed
application software; the server cannot function by itself; and human control
remains important in carrying on the overall business operations. The
Department therefore takes the view that it is generally the location of the
physical business operations, rather than the location of the server alone, that
determines the locality of the profits. In other words, the proper approach is
to focus more on what and where the underlying physical operations were
carried out by the taxpayer to earn the profits in question than on what had
been done electronically.

15.         Decided cases suggest that in ascertaining the locality of a person’s
profits, it may be necessary to have regard to what the person’s agent has done.
The term “agent” can refer to either a natural person or a legal person, but does
not include software or a server, no matter how advanced it is. Nor can an
Internet Service Provider who merely operates a server under a web-site
hosting arrangement be regarded as an agent for this purpose.




                                        5
16.     In relation to the locality of profits, it is relevant to mention that in
HK-TVB International v. CIR 3 HKTC 468 Lord Jauncey, at page 480, stated
that –

          “ It can only be in rare cases that a taxpayer with a principal
            place of business in Hong Kong can earn profits which are
            not chargeable to profits tax under section 14 of the Inland
            Revenue Ordinance.”

In Magna Industrial Company Limited v. CIR 4 HKTC 176 the Court of
Appeal also referred to the same statement and stated, at page 259, that “As a
matter of common sense, this must be so.” Whether a case contains
exceptional features which put it into the “rare case” category depends, of
course, on all the facts of the case.

17.       As a general proposition, where the principal place of business
operations of a company engaged in EC is in Hong Kong, profits earned by the
company will be liable to Profits Tax. By way of illustration –

          (a)    A company which has all of its business operations in Hong
                 Kong apart from operating a server (intelligent or otherwise)
                 which is at its disposal and located outside Hong Kong for EC
                 purposes will be liable to Profits Tax.

          (b)    A company which has all of its business operations outside
                 Hong Kong apart from operating merely a server (intelligent
                 or otherwise) which is at its disposal and located in Hong
                 Kong will not be liable to Profits Tax.

18.        The following examples further illustrate the Department’s views on
this aspect.




                                       6
Example 1 : Trading business

A company carries on a business of selling books in Hong Kong. It operates a
server (at its disposal) located outside Hong Kong. The functions of the
server are to enable customers (local and overseas) to obtain details of books
and price lists; process purchase orders and payments; and allow the
downloading via the Internet of books which are available in a digitized format.
Apart from these functions performed by the server, all business operations of
the company, (such as the procurement of books, the supply of information for
the server, the storage of books, the physical delivery of books, the answering
of customers’ enquiries, and the operational controls of the virtual shop-front)
are carried out by the company in Hong Kong. The profits made by the
company from selling books are chargeable to Profits Tax. Conversely, if the
company were to carry on the business outside Hong Kong and merely operate
the server in Hong Kong, the profits made would not be chargeable to Profits
Tax.

Example 2 : Servicing business

A company operating in Hong Kong is engaged in the provision of consultancy
services. It operates a server (at its disposal) located outside Hong Kong.
The functions of the server include supplying details of its services, answering
enquiries, enabling communications with its clients/potential clients to be made
electronically, and accepting payments for services rendered. The company
obtains consultancy projects from overseas clients through the server. The
work relating to the consultancy services, including collecting and analysing
data, undertaking research, preparing reports, etc., is done in Hong Kong.
The final reports for the projects are either sent to the overseas clients through
e-mail or uploaded to the server in order to be made available for downloading
by the clients concerned. As the activities which in substance give rise to the
profits are carried out in Hong Kong, the profits derived from the consultancy
services are chargeable to Profits Tax. Conversely, if the company were to
carry on the business outside Hong Kong and merely operate the server in
Hong Kong, the profits made would not be chargeable to Profits Tax.




                                        7
Example 3 : Manufacturing business

A manufacturer of watches, which has its principal place of business in Hong
Kong, operates a server (at disposal) located outside Hong Kong. Through
the server, customers obtain details of the company’s products and prices,
negotiate with the company for purchases, order goods, and make payments.
The company’s operations in Hong Kong include preparing information for the
server, answering enquiries from customers, procuring supplies for its
manufacturing operations, manufacturing its products, making delivery
arrangements for the finished products. Again, as the activities which in
substance give rise to the company’s profits are carried out in Hong Kong, the
company is liable to Profits Tax. Conversely, if the manufacturer were to
carry on the business outside Hong Kong and merely operate the server located
in Hong Kong, the profits made would not be chargeable to Profits Tax.



CHARACTERIZATION OF INCOME

19.        Section 15(1) of the Ordinance specifies a number of “sums” that are
deemed to be receipts arising in or derived from Hong Kong from a trade or
business carried on in Hong Kong. It follows that even if a person is not
carrying on a trade, profession or business in Hong Kong, the person may still
be liable to Profits Tax under this deeming section. However, section 21A
provides that the assessable profits in respect of sums which are chargeable
under section 15(1)(a) or (b) shall simply be taken to be 10% of the gross
amount (100% if the amount is derived from an associate). It follows,
because the computations of assessable profits differ, that it may be important
in relation to the taxation of EC to ascertain whether sums have actually been
derived by a person carrying on a business in Hong Kong or are only
chargeable as royalties or licence fees that fall within section 15(1)(a) or (b).

20.      Section 15(1)(b) is particularly relevant in the context of EC. This
sub-section applies in respect of –

          “ sums, not otherwise chargeable to tax under this Part, received by
            or accrued to a person for the use of or right to use in Hong Kong
            a patent, design, trademark, copyright material or secret process
            or formula or other property of a similar nature, or for imparting


                                       8
              or undertaking to impart knowledge directly or indirectly
              connected with the use in Hong Kong of any such patent, design,
              trademark, copyright, secret process or formula or other
              property”.

Whether a particular sum should be regarded as having been received for the
use of or the right to use intellectual property of a kind mentioned above
depends on the terms of the agreement between the parties concerned, taking
into account all the circumstances of the case.

21.        For the purpose of characterizing income from an EC transaction, the
main question to be addressed is the identification of the consideration for the
payment to the non-resident person. If the payment is in truth a payment for a
product or service, it will not come within the scope of section 15(1)(b). On
the other hand, if it is a payment for the use of, or the right to use, copyright
material, it is deemed to be a taxable receipt under section 15(1)(b).

22.        Difficulties in characterizing a payment may arise where the relevant
agreement involves the acquisition or use of computer software or other digital
products. In such a situation, it is important to draw a distinction between a
payment for the use of or the right to use the copyright which subsists in the
software program (where section 15(1)(b) would be applicable) and a payment
for the use of or right to use only the actual software program (where section
15(1)(b) would not be applicable). Examples of the former kind are the right
to make copies for distribution to the public; the right to prepare derivative
programs; the right to make a public performance of the program and the right
to publicly display the program.

23.        The distinction can be further explained by reference to pre-packed
(shrink-wrapped) software. For this type of product, the contract would
generally only grant the customer a licence to use the software to a limited
extent, i.e. to use the software either on a single computer, or on a specified
number of the customer’s computers or network servers. Further, the
customer would not have the right to reproduce, modify or adapt the software
program, or otherwise exploit the copyright in the software. As the payment
for such a software is for the simple use of it, not for the acquisition of any
right to use the copyright, the payment is not regarded as a royalty for Profits
Tax purposes. For digital software downloadable from the Internet, its status


                                       9
is regarded as equivalent to a shrink-wrapped software, if the seller permits the
customer (including a business) to electronically download it on to the latter’s
hard disc or other non-temporary media for a payment for his own use only (i.e.
subject to rights similar to a shrink-wrapped software mentioned earlier). The
downloading may, strictly, constitute the use of the copyright in the software;
however, the use of this copyright is merely incidental to the process of
acquiring, capturing and storing the digital signals, for which the payment is in
fact made. The payment therefore is regarded as a business income and not a
royalty under section 15(1)(b). This approach puts electronic transactions on
a par with those in physical form and is consistent with the principle of
neutrality of treatment mentioned in paragraph 2. This broad principle is also
applicable to other types of digital products, such as those containing images,
sounds or text. Only in cases where the use of the copyright in the digital
product constitutes an essential part of the consideration will the payment by a
customer be regarded as a royalty for section 15(1)(b) purposes.

24.       It should also be noted that section 20B provides that where a
non-resident person is chargeable to tax in respect of sums that fall within
section 15(1)(a) or (b), the tax is charged in the name of the person who paid
the sums. Section 20B also provides that the payer is required to deduct at the
time he pays or credits the non-resident person an amount sufficient to meet the
tax due (“withholding tax obligation”). [See DIPN 17 for further details.]

25.      The following examples further illustrate the Department’s views
concerning the characterization of EC payments.

Example 4 : Electronic ordering and downloading of digital products

A Hong Kong customer orders a digital product (e.g. software, images, sounds
or text) from a server of a commercial provider and downloads the digital
product on to a computer for his own use. He is not allowed to modify, adapt
or copy the product. The payment will not be regarded as a payment for the
use of or right to use the copyright material which subsists in the digital
product. It will instead be regarded as business income of the commercial
provider. If the commercial provider is a “non-resident person” not carrying
on business in Hong Kong, it will not be liable to Profits Tax under section
14(1) or section 15(1)(b). In addition, no “withholding tax obligation” will be
imposed on the Hong Kong customer under section 20B of the Ordinance.


                                       10
However, if instead the Hong Kong customer were to acquire the right to
commercially exploit the copyright material in the digital product, the payment
would fall within the ambit of section 15(1)(b) if made to a non-resident person
not carrying on business in Hong Kong. In addition, the Hong Kong
customer would have a “withholding tax obligation”. On the other hand, if
paid to a commercial provider carrying on a business in Hong Kong, the
payment would be brought to charge under section 14 of the Ordinance.

Example 5 : Application hosting arrangements

A Hong Kong customer who is the owner of, or holds a licence to use, a
software product pays a “non-resident person” to upload the software to a
server (located outside Hong Kong) which is owned and operated by the
non-resident person. The non-resident person does not carry on business in
Hong Kong. Technical support and maintenance of the server is provided by
the non-resident under a hosting arrangement so that the customer can, from
Hong Kong, access and operate the software applications on the host server or
do so by downloading the software to its computer in Hong Kong. This type
of hosting arrangement can apply, for example, to business, accounting and
financial management software applications. The payment received by the
non-resident person is service income which is not chargeable to Profits Tax
under section 14(1) as the non-resident is not carrying on a business in Hong
Kong. There is also no “withholding tax obligation” imposed on the Hong
Kong customer.

Example 6 : Application Service Provider (ASP)

A non-resident person, who does not carry on business in Hong Kong, owns or
holds a licence to use a particular software application in its business as an ASP.
The ASP operates and maintains the software on its own server located outside
Hong Kong. A Hong Kong customer pays the non-resident ASP for using the
software application which automates a particular back-office business function
(e.g. inventory control) for the Hong Kong customer. The Hong Kong
customer’s right to use the software is restricted to the running of the software
program on the ASP’s server. The payment received by the non-resident
person is service income which is not chargeable to Profits Tax under section
14(1) as the non-resident is not carrying on a business in Hong Kong. There
is also no “withholding tax obligation” imposed on the Hong Kong customer.


                                       11
Example 7 : Content acquisition transactions

To attract users to its web site on a server located in Hong Kong, a Hong Kong
server operator pays a non-resident person, who does not carry on business in
Hong Kong, for the right to display on its web site copyright online content
owned by the non-resident person. The payment received by the non-resident
person is taxable under section 15(1)(b) and there is a “withholding tax
obligation” imposed on the Hong Kong server operator. However, if the
Hong Kong server operator had instead paid a non-resident to create new
online content specifically for the server, and the operator had thus become the
copyright owner of the online content, the payment received by the
non-resident person would be business income which would not be chargeable
to Profits Tax as the non-resident is not carrying on a business in Hong Kong.
In this latter situation, no “withholding tax obligation” would be imposed on
the Hong Kong server operator.



CONCLUSION

26.        As pointed out earlier, the position taken by the Department in
relation to EC is that our taxation treatment should be pragmatic and not
impose any impediment to the growth of EC. At the same time, we will not
compromise any necessary action to counteract tax avoidance. The examples
quoted in this DIPN represent simple, straightforward situations and should be
viewed accordingly.




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